Options as Insurance
You wouldn’t think of leaving your house, car, or boat uninsured. But what about your financial assets…stocks, mutual funds, or even IRA’s?
As we enter earnings season in the next week, many investors are potentially at as much financial risk to their assets, as for example, your house would be with an impending hurricane bearing down on your neighborhood.
You don’t even think about the need to insure your home, one of your most valuable assets. Heck, if you have a mortgage, you don’t even have a choice, as the bank demands proof of insurance to qualify for a mortgage. However, if a hurricane were heading your way, you’d certainly know it, as it would be plastered all over the news. Batten the hatches!
Unfortunately most investors not only don’t realize the potential for loss on their stock investments in earnings season, many aren’t even aware of when an earnings announcement date is. If a company either misses their earnings estimate, or even if they show good earnings, but suggest that future guidance is off, the stock can drop significantly the morning after the announcement.
In 2022, NFLX for example, saw 100+ point drops the morning after earnings announcements…TWICE! On was a 20% drop, the second time a 30% drop…in one day. Ouch.
Now while nobody can know what the earnings announcement will be, and even of they did, they certainly don’t know the streets reaction to those announcements. And while of course its possible the stock can gap the morning after, we don’t need protection for good news!
Knowledgeable investors, aware of the risk their positions are in during earnings season, can look to protect their assets the same way they protect their cars and houses… with insurance.
Put options, which gives someone the right to sell an asset at a high price, no matter how low it drops…can be used to protect the value of any stock position. (Assuming the stock is optionable).
In the below example JNJ has been in a demand area, and the company has an earnings announcement on October 17th, before the market opens.
Now obviously we have no way of knowing in advance what JNJ’s earnings will be, nor what will happen to JNJ stock at the open on the 17th. If we were long shares of JNJ, while we’d be thrilled if their earnings were good, and the stock rallied 10-20 points! But what if earnings miss? The stock could gap down substantially. Even a 10% drop, would be over 15 points against your position.
When we’re bullish, our risk is to the downside. But what if we had “stock insurance?” What if we went out today and bought a Nov 10 put at the 150 strike price? We just bought the right to sell shares of JNJ 150 a share no matter how low the stock could drop. The stock could theoretically drop to $20/share, and we’d have the right to sell it at $150.
How can that be? The same reason you’re made whole if you total your car. The value of your car is now zero, yet the insurance company effectively buys it from you at the fully insured value.
This afternoon, that 150 put was selling for $0.90, or $90/contract. 100 shares of JNJ would represent an investment of over $15,000, yet the insurance to protect that investment could have been bought for $90. I’d say that was a smart investment.
If the stock rallies after earnings, great! We’ll lose on the insurance, but we’ll make a lot more on the increased stock price. Make sense?
Hopefully, we won’t need the insurance. Hopefully, the put will expire worthless, just like we hope every other insurance policy we have expires worthless. Does anyone ever hope to file a claim? Is anyone upset their life insurance policy hasn’t kicked in yet this year?
So, you have the ability to insure any financial asset against loss, the same way you can your car, house, boat or even life. You just have to learn how options work, which expiration date to choose, and which strike price to pick.
When do most people realize they don’t have flood insurance? Unfortunately…after the flood! They think they’re insured, and they’re not. Options work the same way. You may buy a put option to insure a position, but could end up choosing the wrong expiration date or strike price, and not be protected the way you thought you were.
At Pinnacle, we’ll teach you the ins and outs of options, and how to use them based on any market condition.
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